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Prospects for the UK economy

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Title: Prospects for the UK economy


1
Economics and Business ExchangeSupported by
Deloitte.
2
Monetary Union in EuropeRay Barrell
3
Outline and Plan
  • Why do we have a Monetary Union in Europe
  • The origins of the project and the idea
  • The political and economic steps to union
  • Why was EMU designed like this
  • What is the role of the ECB
  • Why do we have a Fiscal Pact
  • Has EMU been a success
  • What has happened to inflation
  • Why has output growth been slow
  • What will happen when new members join
  • Does it matter that the UK is outside

4
The monetary union project
  • Plans and discussion for monetary union started
    in the late 1960s and early 1970s
  • Early plans were disturbed by events in the early
    1970s and were delayed
  • Inflation rates in Europe diverged
  • The Exchange Rate Mechanism was set up in 1978 to
    create a converging path to monetary union
  • The Maastricht Treaty in 1990 was designed to set
    up the conditions

5
The political economy of union
  • EMU has been at least as much a political process
    as an economic one
  • Germany was the most successful economy in post
    war Europe
  • Austria and the Netherlands were in effective
    monetary union with Germany from 1983
  • Political pressures fro union came as strongly
    from Netherlands and Belgium as France
  • There was a desire for a tight EMU
  • Others saw EMU as a way of dealing with their own
    political failings, and Italy and Spain saw it as
    a tool to induce structural change

6
Three Dimensions for Policy
  • Ensure high levels of output and sustainable
    trajectories for growth
  • Low and stable inflation
  • High inflation may be related to unstable
    inflation and is often unexpected
  • Contracts are hard to design in a world of
    unexpected inflation variability
  • Limit the scale of cycles and crises
  • Cycles have been becoming more damped
  • The risk of financial crises has not fallen

7
Enhancing growth and stability
  • Output depends on factor inputs and the
    efficiency with which they are used
  • Policy should increase supplies of factors
  • Increased competition increases efficiency
  • The national and international saving and
    investment balance determine real interest rates
  • Lower real interest rates increase capital and
    output
  • Lower risk premia increase the level of capital
    per unit of output
  • Crafts and OMahony show core Europeans have 25
    more capital per head than the UK

8
Inflation and Risk
  • Lower inflation and output volatility reduces
    risk and affects decision making
  • Lower premia mean a lower cost of capital, more
    investment and a higher capital stock
  • Higher capital means more output for a given
    level of labour input
  • Exchange rate instability increases risk and
    reduces investment and output
  • Monetary union membership for the UK may raise
    inflation volatility and will reduce exchange
    rate volatility

9
Labour productivity in EU (person hour in ppp)
relative to the US
10
Productivity and growth
  • Output per person hour is higher in core Europe
    than in the US or the UK
  • Over the last 30 years the core Europeans have
    caught up with and overtaken the US
  • UK performance has improved marginally recently

11
Participation, hours and activity
  • Participation rates are lower in core Europe than
    the US or the UK
  • Hours are shorter in core Europe
  • Methods of constructing the national accounts
    differ significantly
  • Core Europe has a lead in output

12
The events of the 1970s
  • The collapse of Bretton Woods was triggered by a
    German refusal to accept the inflation rate
    determined by US policy
  • Outcomes varied across Europe, but German policy
    was much more successful
  • Germany kept inflation stable
  • The UK and Italy performed badly
  • It is not clear that floating exchange rates were
    a success

13
Inflation
14
The ERM and the path to Union
  • Exchange rates became more stable in the 1980s
    with the ERM
  • Inflation began to converge but realignments were
    common
  • Exchange rates became harder
  • Fiscal policy had been loose in the 1980s
  • The Maastricht Treaty put constraints on fiscal
    policy
  • Deficits were limited
  • Debts had a ceiling
  • The ERM crisis of 1992 to 93 made the process
    look unstable

15
Choosing the members
  • In the early 1990s plans involved a small
    membership with tight constraints
  • Fiscal constraints were the most important
  • Deficits had to be under 3 of GDP
  • The debt criteria disappeared
  • Exchange rate stability and interest rate
    convergence was required
  • These were not always imposed
  • Why was a deficit ceiling chosen, and what was
    wrong with the Golden rule

16
What is the constitution
  • The monetary constitution gives the ECB the right
    to choose its own inflation target
  • Is this a democratic deficit
  • What are the role of rules
  • The background to the ECB must be seen in German
    Ordliberalism (not Mill and utility) where rules
    constrain politicians
  • The three pillars of the constitution are price
    stability, competition and the constrained state
    with dispersed responsibility

17
EMU and the single market
  • The Common Market has always been more than a
    free trade area, and it involved integration of
    standards and rules
  • The single market has removed barriers to trade
    and to capital mobility
  • It was designed to enhance competition
  • Competition reduces rents and raises output
  • The first phase increased trade
  • The removal of the currency barrier was the last
    step and appears to have increased cross border
    capital mobility

18
Fiscal Pacts in EuropeBackground
  • Debt stocks rose to high levels by the early
    1990s raising real interest rates
  • Debt stocks rose because fiscal policy was
    expected to reduce unemployment
  • High unemployment was structural not cyclical and
    fiscal policy did not work
  • Lower debt was needed to help reduce real
    interest rates and raise equilibrium output
  • Labour market polices were needed to deal with
    structural unemployment

19
Why do we need Fiscal Pacts
  • Governments need fiscal pacts with their people
    to enhance growth
  • The assurance of no excessive borrowing reduces
    expected real interest rates
  • Lower borrowing reduces the risk premium
  • It lowers the risk of default
  • it reduces the pressure for higher inflation to
    be used to reduce the debt burden
  • The UK has a Fiscal Pact between the people and
    the state based on the Golden rule
  • Does the golden rule have any basis in economic
    theory or it is just a guideline

20
Why does EMU need a Pact
  • In Monetary Union the gains from fiscal expansion
    are mainly in the home country
  • Spillovers are shared by all members
  • Increased real interest rates are shared, and in
    the long run reduce output everywhere
  • The costs of higher inflation are shared because
    of the pressure of the risk of debt default are
    shared everywhere
  • Default risks lie with the country and the
    lenders not the Euro Area

21
EMU and monetary target independence
  • The ECB has the constitutional remit of
    maintaining price stability
  • It started with a range of 0-2 per cent but was
    clear that this was not centred at 1.0
  • It now has a target of close to but below 2.0
  • How can 2 per cent be price stability
  • Why does price stability matter
  • Longer term contracts are secure
  • Second round effects from oil seem limited
  • What are the achievements

22
Monetary Policy
  • Monetary policy is handled to the ECB
  • It has goal and instrument independence
  • It is not clear that it is fully effective
  • Policy under the Bundesbank was clear
  • Behaviour was constant over 25 years,
  • Inflation and its volatility were the lowest in
    the G7
  • Real exchange rate volatility was low
  • ECB behaviour is clearly different
  • It appears to have less response to deviations of
    inflation above and below target

23
Euro Area Inflation Expectations
  • Since oil price began to rise
  • US inflation expectations up 0.7 pp on average
    p.a. over next 10 years, and 1 pp over next 5
    years
  • Euro Area expectations up just ¼ pp
  • Exchange rate developments
  • The decline in the dollar raise US inflation
    expectations
  • Monetary policy regimes
  • The US may be expected to be more accommodating
  • Different cyclical positions

24
Has EMU been a success?
  • We need to judge EMU on growth, stability and
    inflation
  • Has inflation been near target
  • Has the exchange rate been stable
  • Has growth been satisfactory
  • We also need to ask what else has been going on,
    and how this affected individual countries ands
    the Union as a whole
  • Globalisation and trade agreements
  • Technical change and new products

25
Inflation performance
26
Fiscal policy has the SGP worked
27
Why and where has growth been weak
  • Growth has been weak in Germany and Italy and
    recently in the Netherlands
  • Performance in France has been OK and robust in
    Spain and Finland
  • Overall growth has been weak but this may not be
    because EMU has been set up

28
Misalignments and the effects of entry
  • Overvalued currencies on entry would have caused
    slower growth
  • Germany and Italy were overvalued, Netherlands
    and Spain undervalued
  • Growth differentials partly reflect adjustment
  • Germany controlled policy until 1999, and it was
    designed to reduce volatility there
  • EMU will have raised perceived volatility in
    Germany but reduced it elsewhere
  • All these should net out leaving growth for EMU
    unchanged

29
Technical progress and productivity growth
  • Germany has had slow growth in labour
    productivity
  • blamed on inflexible labour markets
  • Other countries in EMU are similar
  • The US has had a wave of technical progress
    raising labour productivity
  • The US moved first with new products, and its
    education system and labour market were more
    suited to these developments

30
Trade and globalisation
  • World trade agreements have changed potential
    output in EMU
  • Italy has been badly hit by the ATC because of
    its production structure
  • Italy has had very major fiscal consolidation
    over the last decade

31
Products and processes
  • The world economy has been going through a period
    of product innovation after decades of process
    innovation
  • EMU may have slow growth because of the design of
    its institutions
  • Long term attachments between firms and workers
    with extensive on the job training are different
    from the US pattern
  • EMU styles may be better for process innovation
    and it may be unwise to change
  • We may have seen waves of catching up and falling
    behind because of these difference

32
Will expansion make EMU more difficult to sustain
  • Estonia, Lithuania and Slovenia may join this
    year if inflation and budget deficits allow them
    to do so
  • Why are they joining and will it change anything
    in this case not much
  • Poland, Czech Republic and Hungary will join by
    2010 Poland is half of NMS
  • For given inflation in core Europe they mat raise
    the required inflation target by 0.06 initially
    and 0.2 perhaps in 2010
  • These expansions will be easier to manage than
    the inclusion of Italy and Spain at the outset

33
Does it matter that the UK is outside EMU
  • The SMP and economic integration is not complete
    without UK membership
  • The costs to EMU are likely to be small
  • The costs to the UK may exist
  • It is not clear that the UK will be more stable
    and grow more outside EMU but costs of staying
    outside will be low
  • Real exchange rate stability is less likely
    outside and this is the major factor affecting
    investment risk premia

34
Conclusion what will happen to EMU
  • Exchange rate regimes fall apart slightly more
    often than countries do
  • The economic benefits are clear, but the
    political will has to remain
  • It is not clear that Italy would find life any
    more comfortable outside EMU, but devaluation and
    inflation can help when you have structural
    problems
  • EMU may be a better option than a repetition of
    1933 to 1945

35
Economics and Business ExchangeSupported by
Deloitte.
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